Johnson Controls Inc., a U.S. maker of car batteries and heating and ventilation equipment, announced on Monday that it had agreed to acquire Ireland-based Tyco International Plc in a $16.5 billion deal, effectively shifting its headquarters out of the U.S. in a so-called corporate inversion. Although IRS issued a second round of administrative guidance last year in efforts curb inversions, this latest deal highlights the limits in IRS’s authority to truly prevent these deals.

Background. Corporate inversions (also called “expatriation transactions”) generally involve a U.S. corporation that engages in a series of transactions with the effect of moving its headquarters from the U.S. to a lower-taxed foreign jurisdiction. The transactions might be effected by the U.S. corporation becoming a wholly owned subsidiary of a foreign corporation (through a merger into the foreign corporation’s U.S. subsidiary) or by transferring its assets to the foreign corporation. If the transaction is respected, U.S. tax can be avoided on foreign operations and distributions to the foreign parent, and there are opportunities to reduce income from U.S. operations by payments of fees, interest, and royalties to the foreign entity.

Inversion transactions are generally governed by Code Sec. 7874, which was enacted in 2004 as part of the American Jobs Creation Act (P.L. 108-357). Under Code Sec. 7874, a foreign corporation is treated as a U.S. corporation for all purposes (i.e., the benefits of being treated as foreign are lost) of the Code where, under a plan or series of related transactions:

1. the foreign corporation completes, after Mar. 4, 2003, the direct or indirect acquisition of substantially all the properties held directly or indirectly by a U.S. corporation;

2. shareholders of the U.S. corporation obtain 80% or more of the foreign corporation’s stock (by vote or value) by reason of holding their U.S. shares (the “80% test”); and

3. the foreign corporation, and corporations connected to it by a 50% chain of ownership (the “expanded affiliated group,” or EAG), don’t have “substantial business activities” in the foreign corporation’s country of incorporation or organization when compared to the total business activities of the group. (Code Sec. 7874(b); Code Sec. 7874(a)(2))

RIA observation: Put otherwise, in order to avoid being treated as a U.S. corporation under the above rules, the resulting entity must be more than 20% foreign-owned, meaning that the target foreign company must be at least 25% the size of the U.S. corporation.

Substantial business activities, for purposes of (3), above, are defined as 25% of the firm’s employees, assets, and sales being in the foreign country. (Reg. § 1.7874-3)

A separate set of rules apply to inversion transactions where the domestic corporation’s shareholders obtain at least 60% but less than 80% of the foreign corporation’s stock (the “60% test”). In general, the tax benefits associated with being a foreign corporation are reduced, and the expatriated entity’s “inversion gain” (defined as any income recognized during a 10-year period by reason of the acquisition, not offset by a net operating loss (NOL) or foreign tax credit) is taxed at the maximum corporate rate. (Code Sec. 7874(a)(2)(B)) This is sometimes referred to as a “toll charge,” and legislative history described it as being paid on transactions that accompany or follow an inversion transaction and are designed to “remove income from foreign operations from the U.S. taxing jurisdiction.” The lost benefit of otherwise applicable tax attributes like NOLs essentially serves as a penalty.

RIA observation: This is the first major inversion announced since the November 2015 guidance, the limitations of which Treasury Secretary Jacob Lew candidly acknowledged, stating that “only legislation can decisively stop inversions.”

Details on the latest merger. U.S.-based Johnson Controls, which has a market value of $23 billion, makes heating and ventilation systems and car batteries, while Ireland-based Tyco, valued at $13 billion, specializes in fire protection systems. According to Reuters, the Johnson Controls-Tyco merger will combine Johnson Controls’ commercial buildings business with Tyco’s fire security offerings, accelerating Johnson Controls’ transformation following its decision to spin off its automotive parts unit (scheduled to take place in the first fiscal quarter of 2017).

The merger will create savings of at least $500 million in the first three years, the companies said, including annual tax savings of about $150 million from basing the combined company in Ireland.

Johnson Controls’ shareholders will own about 56% of the combined company, with Tyco shareholders owning the remainder, due in part to a cash consideration of about $3.9 billion that Johnson Controls shareholders will receive.

RIA observation: Thus, Johnson Controls will come under the threshold in the “60% test,” above, avoiding triggering those inversion rules.